Tag Archives: Investment Advisers Act of 1940

Investment Advisor Barred From IA Industry For Matching Trade Fraud

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Hedge fund managers should not match trades between commonly managed accounts in thinly traded (or illiquid) securities as this may pose potential problems under the Investment Advisors Act of 1940.  This holds true whether the hedge fund manager is registered or unregistered.  As the release below shows, the manager may be subject to fines and/or other penalties for such trading.  If a hedge fund manager does wish to engage in such trading, he should discuss this option with a hedge fund attorney.  Please contact us if you have any questions.  Continue reading →

Overview of Investment Advisers Act of 1940

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One of the most important set of the federal securities laws which relate to hedge fund managers is the Investment Advisers Act of 1940 (Investment Advisers Act).  The Investment Advisers Act provides the manner in which investment advisers will register with the SEC, provides the laws that must be followed as an investment advisor, and makes it illegal for both registered and unregistered investment advisors to act fraudulently toward any investors.

If a hedge fund manager is registered as an investment advisor with the SEC then the manager should make sure he understands all parts of the Investment Advisers Act. Below I’ve highlighted and discussed those provisions which are most important to a hedge fund manager.  The entire act can be found here: Investment Advisers Act of 1940.

Definition of Investment Adviser

The term investment adviser is very broad.  Section 202(a)(11) provides:

“Investment adviser” means any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities;

but does not include

(A) a bank, or any bank holding company as defined in the Bank Holding Company Act of 1956, which is not an investment company, except that the term “investment adviser” includes any bank or bank holding company to the extent that such bank or bank holding company serves or acts as an investment adviser to a registered investment company, but if, in the case of a bank, such services or actions are performed through a separately identifiable department or division, the department or division, and not the bank itself, shall be deemed to be the investment adviser;

(B) any lawyer, accountant, engineer, or teacher whose performance of such services is solely incidental to the practice of his profession;

(C) any broker or dealer whose performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefore;

(D) the publisher of any bona fide newspaper, news magazine or business or financial publication of general and regular circulation;

(E) any person whose advice, analyses, or reports relate to no securities other than securities which are direct obligations of or obligations guaranteed as to principal or interest by the United States, or securities issued or guaranteed by corporations in which the United States has a direct or indirect interest which shall have been designated by the Secretary of the Treasury, pursuant to section 3(a)(12) of the Securities Exchange Act of 1934, as exempted securities for the purposes of that Act; or

(F) such other persons not within the intent of this paragraph, as the Commission may designate by rules and regulations or order.

Pre-requiste for Registration

Only those managers which manage at least $25 million in assets are eligible to register with the SEC.  If a manager has less than $25 million of assets under management, then the manager will be subject only to the registration with the managers state of residence (if required).  Specifically Section 203A(a)(1)(A) provides:

No investment adviser that is regulated or required to be regulated as an investment adviser in the State in which it maintains its principal office and place of business shall register under section 203, unless the investment adviser – has assets under management of not less than $ 25,000,000, or such higher amount as the Commission may, by rule, deem appropriate in accordance with the purposes of this title; …

Investment Adviser Registration Requirement

In general, all investment advisors must register with the SEC pursuant to Section 203(a).

Except as provided in subsection (b) and section 203A, it shall be unlawful for any investment adviser, unless registered under this section, to make use of the mails or any means or instrumentality of interstate commerce in connection with his or its business as an investment adviser.

Exemption from registration

While the definition of investment adviser is sufficiently broad to include most all hedge fund managers, there is a widely used exemption from the registration provisions.  Section 203(b)(3) provides:

The provisions of subsection (a) [the registration provisions noted above] shall not apply to … any investment adviser who during the course of the preceding twelve months has had fewer than fifteen clients and who neither holds himself out generally to the public as an investment adviser nor acts as an investment adviser to any investment company registered under title I of this Act, or a company which has elected to be a business development company pursuant to section 54 of title I of this Act and has not withdrawn its election. For purposes of determining the number of clients of an investment adviser under this paragraph, no shareholder, partner, or beneficial owner of a business development company, as defined in this title, shall be deemed to be a client of such investment adviser unless such person is a client of such investment adviser separate and apart from his status as a shareholder, partner, or beneficial owner;

There are two important items to note here.  First, the investment adviser cannot have more than 15 clients over a 12 month rolling period.  A hedge fund counts as a single client for these purposes.  Second, the investment adviser

Prohibited Transactions

The act has very strong anti-fraud provisions.  Most SEC actions against investment advisers will be based on this section of the act.  Section 206, in full, provides:

It shall be unlawful for any investment adviser, by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly –

(1) to employ any device, scheme, or artifice to defraud any client or prospective client;

(2) to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client;

(3) acting as principal for his own account, knowingly to sell any security to or purchase any security from a client, or acting as broker for a person other than such client, knowingly to effect any sale or purchase of any security for the account of such client, without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction. The prohibitions of this paragraph (3) shall not apply to any transaction with a customer of a broker or dealer if such broker or dealer is not acting as an investment adviser in relation to such transaction;

(4) to engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative. The Commission shall, for the purposes of this paragraph (4) by rules and regulations define, and prescribe means reasonably designed to prevent, such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative.

Other Important Sections

There are other important sections to the act which include the following:

Section 204 – Record Keeping Requirements

Section 205 – Investment Advisory Contracts

Section 222 – State Regulation of Investment Advisers

What licenses do you need to start or manage a hedge fund?

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Question: What licenses do you need to start or manage a hedge fund?

Answer: This is a question that comes up quite often. Many people wonder whether they need a series 7 license or the series 65 license or the series 3 to manage a hedge fund. First, a potential hedge fund manager does not need to have a series 7 license in order to manager a hedge fund. The series 7 license is the general securities representative licese which allows an individual to be a representative (broker) of a FINRA registered member firm (brokerage firm or broker-dealer). The series 7 allows a representative to take and place trades for a customer. It is also a prerequisite for many of the other FINRA exams (such as the series 24). Because the hedge fund in not regulated as a broker, a hedge fund manager does not need to have a series 7 license (assuming that the manager is also concurrently acting as a broker-dealer representative).

Second, a start up hedge fund manager may need to have a series 65 license in order to become registered as an investment adviser. There are two potential ways a hedge fund manager would be required to register as an investment adviser – under the federal rules (the Investment Advisers Act of 1940) or under the various state rules (commonly referred to as the state blue sky laws). If a manager is required to register with the SEC under the Advisers Act* then, for federal purposes, the manager will not need to have taken the Series 65. However, the Advisers Act allows states to impose certain requirements on all federally registered investment advisers with a place of business in their state. Generally the states will require all federally registered investment advisers to “notice file” in their state which entails paying a fee to the state. The state can also require that all investment adviser representatives have the series 65 license. This means that anyone who talks to clients/investors or makes any trading decisions or analysis will need to have this license. The definition of investment adviser representative basically encompasses every employee or owner of the investment adviser other than secretary type employees. If you are a federally registered investment adviser you should discuss whether members of your team need to be licensed as representatives at the state level.

If you are not a federally registered investment adviser (generally all managers with less than 30 million of assets under management) then you will need to determine whether your management firm needs to be registered as an investment adviser at the state level. Many states require investment advisers with a place of business** in the state to register. Some popular states that require investment adviser registration are California, Texas, Washington and Colorado. However, there are many states which have exemptions from the registration requirements. Some popular states that have exemptions (through regulation or special order) from investment adviser registration for hedge fund managers are New York, Connecticut, Florida and Georgia. Again, you should speak with your legal counsel or compliance professional to determine whether your hedge fund management firm will need to be licensed as an investment adviser in the state.

Finally, if the hedge fund trades futures or commodities then the manager may need to be registered as a commodity pool operator with the National Futures Association. In order to register as a commodity pool operator at least one person at the management company will need to take the Series 3 exam. For more information on the Series 3 exam and this part of the registration process please read how to register as a CPO or CTA.

* Many potential hedge fund managers are confused with whether a management company will need to be registered as an investment adviser with the SEC. The answer is that in most cases a hedge fund manager will not have to be registered as an investment adviser with the SEC because of an exemption provision within the investment advisers act. Section 203(b)(3) of the Advisers Act specifically exempts from the registration provisions “any investment adviser who during the course of the preceding twelve months has had fewer than fifteen clients and who neither holds himself out generally to the public as an investment adviser nor acts as an investment adviser …” The term “client” in the hedge fund context means a “corporation, general partnership, limited partnership, limited liability company, trust …, or other legal organization … to which you provide investment advice based on its investment objectives rather than the individual investment objectives of its shareholders, partners, limited partners, members, or beneficiaries…”

This means that as long as a hedge fund manager will not need to count the investors in the hedge fund as his “client” and that the hedge fund itself is the only “client.” You will probably recall that a couple of years ago the SEC proposed a change to the rules under the Advisers Act that required a manager to count all of the investors in the hedge fund as clients. Under the proposed rule hedge fund managers would have been required register with the SEC (if they had at least $30 million under management), but Phillip Goldstein successfully challenged the SEC in court. His successful challenge to the rule change allows hedge fund managers to escape SEC regulation.

** “Place of business” of an investment adviser means: (1) An office at which the investment adviser regularly provides investment advisory services, solicits, meets with, or otherwise communicates with clients; and (2) Any other location that is held out to the general public as a location at which the investment adviser provides investment advisory services, solicits, meets with, or otherwise communicates with clients.